Economics 214. Macroeconomics

Transcription

1 Economics 214 Macroeconomics

2 Some definitions to note CHAPTER 1: INTRODUCTION Purchasing power parity refers to the standard measure to compare standards of living across different countries with different currencies. Labour market institutions refer to well-established rules, policies and norms that are accepted as part of the labour market. Labour market rigidities refers to when legislation in the labour market is very stringent and not prone to change. When we compare countries with each other in terms of economic performance, we usually evaluate the following indicators The output, or real GDP; The population; The output per person, or real GDP per person; The unemployment rate; The inflation rate; and The budget deficit (or surplus). All other information in Chapter 1 is specific statistics which does not need to be studied for the sake of this module. The above definitions and the comparison criteria for economic performance are the only theory that can be extracted from Chapter 1.

3 THE TRANSLATION OF AMOUNTS CHAPTER 2: INTRODUCTION Amount English (US) English (UK) million million billion milliard trillion billion For the purpose of economic data, we use the English (US) version for amounts, because it is generally the accepted terminology for the financial world. AGGREGATE OUTPUT The gross domestic product (GDP) refers to the total market value of all final goods and services produced annually within a country s borders. GDP is the measure of aggregate output in the national income accounts. GDP can be calculated on different methods, such as 1. GDP is the value of the final goods and services produced in the economy during a given period (aggregate production). In this method the importance is placed on the summation of the value of final goods, which are goods that are ready for sale to consumers, as opposed to intermediate goods, which are any goods that are used in the production of other goods. Intermediate goods are never included in the calculation of GDP. Consider the following example. A farmer grows wheat and sells it to a baker for R100. The baker uses the wheat to bake breads and sells it for R200. In this example the bread is the final good and therefore the GDP will be equal to R200 in this case. This method of calculating the GDP therefore includes the recording and adding up of the production of all final goods. 2. GDP is the sum of the value added in the economy during a given period (aggregate production). In this method the importance is placed on the value added, which refers to the value of the production minus the value of the intermediate goods used in production. Consider the previous example. In the first step of production, the farmer adds value of R100 because the cost of production is R100 and there was no intermediate goods. In the second step, the baker adds value of R100, as well, because the cost of production is R200 and the intermediate goods amount to R100. In total, the GDP also amounts to R200.

4 CHAPTER 3 - THE GOODS MARKET THE COMPOSITION OF GDP Initially, we defined GDP as a sum of goods and services produced, but it can also be defined as a sum of all goods and services consumed. When we defined the GDP in terms of the goods and services consumed, the decomposition will look as follows: Private consumption expenditure (C) Gross private fixed investment (I) 248 Non-residential 226 Residential 22 + Government spending (G) 555 +/- Net exports (141) + Exports (X) Imports (Im) (612) Inventory Investment 10 Residual items (8) GDP (Y) From the abovementioned, we have to define certain terminology. Private consumption expenditure, or simply consumption, denoted by C, refers to the goods and services purchased by consumers, which can range from food to airline tickets. Gross private investment, or simply investment, denoted by I, is the sum of private non-residential investment, which is when firms purchase new factories or machines, and private residential investment, which refers to when households purchase new houses or flats. In economic terms, investment refers to the purchase of any capital goods, as can be seen above, If investments refer to the purchase of gold or shares, it is specifically called financial investments. Government spending, denoted by G, refers to the purchases of goods, services and investment spending by the national, provincial and local governments. Government spending includes goods such as providing textbooks and medical services, but does not include government transfers, such as social grants or interest payments on government debt, because it might be government spending, but it does not purchase anything. The sum of consumption, investment and government spending gives us the total purchases of consumption and capital goods by South African consumers, firms and governments.

5 CHAPTER 4 - FINANCIAL MARKETS The current governor, or president, of the South African Reserve Bank (SARB) is Lesetja Kganyago. SEMANTIC TRAPS Income refers to the return for the labour of an individual, together with interest and dividends received. Income is a flow variable, which means it will always be expressed per unit of time, e.g. R200 per hour. Saving is the part of a consumer s after-tax income that is not spent. Savings is also a flow variable. Financial wealth, or wealth, refers to the value of an individual s financial assets minus all of their financial liabilities. Wealth is a stock variable, which is measured at a given time, e.g. my current wealth is R200. Investment is a term that economists reserve for the purchase of new capital goods, while financial investments refers to the purchase of any financial assets. THE DEMAND FOR MONEY Money, which is used for transactions, earn no interest. We distinguish between two types of money: coins and notes (currency), which does not earn interest, but can be used for transactions; and checkable deposits, which earns interest because it as a financial investment, but cannot be used for transactions. Money has the following four main functions: It is a medium of exchange, i.e. it is accepted in exchange for goods and services, which has the benefit of eliminating the need for a barter economy, which economises time and effort spent. It is a unit of account, i.e. it is a standard unit or agreed measure for quoting or stating prices, for example the Rand value of an item. This function helps economists to easily determine debt obligations, taxes owed or GDP figures. It is a store of value, in the sense that money is an asset that can be used to transfer purchasing power from one period to a future period. It is a standard of deferred payment by virtue that is an accepted way of settling debt. Bonds earn a positive income from the interest rate, i, but cannot for used for transactions. It is therefore not as convenient as money due to the administration involved. There is usually a small fee attached to obtaining a bond, attributed to the brokerage fee.

6 CHAPTER 5 THE IS-LM RELATION THE GOODS MARKET AND THE IS RELATIONSHIP Previously we assumed that equilibrium in the goods market exists when production, Y, is equal to the total demand for goods, Z, i.e. Y = Z, which we referred to as the IS condition. This was based on the assumption that the interest rate does not affect the demand for goods and that investment was a constant. This gave us an equilibrium condition of Z = C(Y T) + I + G, by dropping the assumption of linearity for the consumption function. In this section we are dropping the assumption that interest rates do not affect the total demand for goods, because investment will no longer be seen as a constant, but rather investment will become endogenous to the model. Investment, sales and the interest rate. The two main factors that affect investment: If the level of sales (Y) of a company rises, firms will increase production to meet demand and will thus require additional investments. Because level of sales is very difficult to measure, we will be using a proxy variable, which is income (Y). There is a direct relationship between the level of sales and investment if the level of sales increases, so does investments; and if the level of sales decrease, so will investments. If the interest rate (i) increases, it is more expensive to borrow money. Borrowed money is usually required for company s to acquire investments, which means if the cost to borrow money increases, the company will have lower investments. This tells us that investments and the interest rate is inversely related if the interest rate increases, investments will decrease; and if the interest rate decreases, investments will increase. Regarding interest rates, we make the following assumptions: All firms are allowed to borrow money at the same interest rate, which is equal to the interest rates on bonds, as determined in the previous chapter. Furthermore, we disregard the difference between the nominal interest rate (the interest rate in terms of Rands) and the real interest rate (the interest rate in terms of goods). The two abovementioned factors can be illustrated in terms of the behavioural equation given by The positive sign under Y indicates the direct relationship between the level of sales and investments, and the negative sign under i indicates the inverse relationship between the interest rate and investment.

7 CHAPTER 6 - LABOUR MARKET AN OVERVIEW OF THE LABOUR MARKET To understand the labour market, the following terminology needs to be defined. The working-age population refers to the number of people between the ages of 15 and 65 in a country s population. The working-age population is a subset of the country s total population. Unemployed (U) refers to the number of people who do not have a job, but looking for work. To be considered unemployed, an individual needs to meet two criteria The individual did not have a job seven days prior to when unemployment is measured; The individual wants to work and is available to start work within one week of a business interview; and The individual has been looking for a job in the last four weeks of when the unemployment is measured. Employed (N) refers to the number of people who do have a job at the time of measurement. The labour force (L) refers to all individuals in the country who are of working age, willing and able to work. The labour force is a subset of the working-age population. It therefore refers to the sum of unemployment and employment, which can be expressed as L = N + U. In South Africa we make use of two definitions of the labour force: o According to the broad definition, the unemployed consists of all those who are willing to accept a suitable job if it is offered to them. o According to the narrow definition, the unemployed includes only those who actively looked for work in the preceding four weeks Those who are neither able nor willing to work are out of the labour force, and said to be economically inactive. Based on the above definitions, we will only consider someone who is looking for a job as unemployed. If an individual is not looking for a job, they will considered to be not part of the labour force. Alternatively, it can occur that individuals stop looking for a job because the unemployment rate is very high and they have given up hope on finding a job. These individuals will be classified as discouraged workers. Due to the existence of discouraged workers, the unemployment rate is a very poor indicator of the conditions in the labour force. Accordingly we introduce the concept of the participation rate, which refers to the ratio of the labour force to the total population working age, which refers to any individuals in the age group of 15 to 65. The participation rate can therefore be calculated by the following formula: Labour force Number of people in the working age population. An unemployment rate may reflect two very different realities, i.e. there could be an active labour market, with many separations and many hires, which means that

8 CHAPTER 7: THE AD/AS MODEL AGGREGATE SUPPLY (AS) The aggregate supply relation captures the effects of output on the price level. It is derived from the behaviour of wages and prices, i.e. by using the wage-setting relation and price-setting relation from the previous chapter. To do this, we need to adjust one of our adjustments first. Before, we assumed that the expected price level is equal to the actual price level, but this is in fact only true in the medium run. This means that the actual price level will be equal to the actual price level in the medium run, but not in the short run. To derive the aggregate supply curve, we first need to do some algebra on our initial wage-setting and price-setting equations. 1. Rewrite the initial equations The wage-setting equation is given by W = P e F(u, z) The price-setting equation is given by P = (1 + μ)w 2. Substitute the wage-setting equation into the price-setting equation P = P e (1 + μ)f(u, z) 3. Replace u with 1 N L 4. Replace N with Y P = P e (1 + μ)f (1 N L, z) P = P e (1 + μ)f (1 Y L, z) From this equation, we can conclude that the price level depends on the expected price level, P e, the level of output, Y,, z, and L. We do, however, assume that, z, and L are kept constant. Properties of the AS Relation The AS relation has two important properties, which are 1. Given the expected price level, an increase in output leads to an increase in the price level. If output increases, we will see an increase in employment, because Y = N. This will then lead to a decrease in the unemployment and accordingly the unemployment rate. The lower unemployment rate leads to an increased nominal wage, which will be reflected as an increase in the prices set by firms and will accordingly increase the price level. There is therefore a direct relationship between the output and the price level, i.e. if the output increases, so does the price level; and vice versa.

9 CHAPTER 8 THE PHILLIPS CURVE, THE NATURAL RATE OF UNEMPLOYMENT, INFLATION, ACTIVITY AND NOMINAL MONEY GROWTH INFLATION, EXPECTED INFLATION AND UNEMPLOYMENT The first step to this chapter is to realise that the AS-relation can be rewritten in terms of inflation, expected inflation, and the unemployment rate. This can be done by following these steps. 1. Rewrite the initial equation for the AS-relation P = P e (1 + μ)f(u, z) 2. Substitute the simple, linear form of the function F, i.e. F(u, z) = 1 αu + z P = P e (1 + μ)(1 αu + z) This captures the notion that the higher the unemployment rate, the lower the wage; and the higher the z variable, the higher the wage. α is a coefficient that is used to capture the strength of the effect of unemployment on the wage. 3. The final form of the equation π = π e + (μ + z) αu The derivation of the final form of this equation is not necessary, but it is included in the appendix of chapter 8 on page 233 of the Macroeconomics textbook. According to the final form of the equation, we can draw the following conclusions. An increase in the expected inflation, e, leads to an increase in actual inflation,. This is derived from the equation in step 2 from above. Given last period s price level, a higher price level in the current period implies a higher rate of increase in the price level from the previous period to the current period, which refers to higher inflation. Similarly, given last period s price level, a higher expected price level in the current period implies a higher expected rate of increase in the price level from the previous period to the current period, which refers to higher expected inflation. Given expected inflation e, an increase in the mark-up,, or an increase in the z variable, leads to an increase in inflation,. This is also derived from the equation in step 2 from above, because if there is an increase in the mark-up or the z variable, there will be an increase in the price level, which means we can use the same reasoning as in the previous statement to show the effect that mark-up and the z variable has on the inflation rate. Given expected inflation, e, an increase in the unemployment rate, u, leads to a decrease in inflation,.